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Hermes: The iron ore meltdown in three charts

After a strong second quarter, the price of iron ore has resumed its collapse amid strong supply, weak demand and rising protectionism in the steel market. These three charts explain how the market arrived at this situation and illustrate the implications for credit investors, says Andrey Kuznetsov, Credit Analyst at Hermes Credit.

Chinese smelters drive demand
China’s industrialisation has driven a substantial increase in the demand for iron ore in the past 25 years. The nation’s annual consumption of steel has increased more than 10-fold from about 70m tonnes in the early 1990s to more than 700m tonnes in recent years. China’s share of global iron ore imports has increased from about 10% in 1990 to 81% in 2014, making the appetite of its steel industry the most important demand-side force in the market. Weaker Chinese demand since late 2013 is therefore impacting the market.

Figure 1. China steel consumption

Source: Bloomberg, Hermes Credit as at May 2015

Australia and Brazil are key suppliers
This trend has encouraged iron ore-rich countries like Australia and Brazil to increase production. The nations accounted for 92% of total global exports of iron ore in 2014, split 62% and 30% respectively. Other major exporters are South Africa, Canada and India, which supply 4%, 3%, and 1% respectively. Consequently, exports by Australia and Brazil are the most important supply-side driver in the iron ore market.

The Q2 rally is done
Supply-side shortages drove the rally in iron ore prices, from $47 per tonne at the start of April to $65.5 per tonne in mid-June, which is the period that typically experiences the strongest seasonal demand. The shortages were caused by the temporary closures of mines by smaller producers and slower output from some of the majors. In recent weeks, the continued decline in Chinese steel prices and greater protectionist measures being either implemented or contemplated across the globe exacerbated the effects of a seasonally slower quarter. On the supply side, some of the smaller players resumed operations, Atlas Iron being one example. Statistics released last week by the Port of Port Hedland, in Western Australia, show that June was a record month for exports, with year-to-date volumes up 13% compared to this time last year. A record daily run rate of 1.28m tonnes per annum was also recorded. This combination of strong supply, low prices and protectionism has led to a sharp re-pricing of the iron ore market.

Figure 2. Prices of iron ore and steel

Source: Bloomberg, Hermes Credit as at 9 July 2015

What’s next?
Looking further ahead, the major producers will continue to increase capacity to compensate for lower prices, forcing less cost-competitive players out of the market. We should expect Vale, BHP Billiton, Rio Tinto and other producers to seek to expand their operations. However, demand is not expected to match this increase, due to the still-sluggish recovery in Europe and the slowdown in emerging markets – particularly in China. Without a recovery in steel prices, we don't expect a significant increase in iron ore prices in the short term. The investment implications are clear: an underweight exposure to iron ore producers and steel makers is appropriate until a renewed equilibrium in steel markets, supported by an enduring source of demand, is reached.

Figure 3. Steel prices in the US, Europe and China

Source: Bloomberg, Hermes Credit as at 9 July 2015

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Andrey KuznetsovCFA, Hermes Senior AnalystAndrey joined Hermes in 2013 as a credit analyst. Prior to this he was a credit analyst for a multi-strategy credit fund at BCM & Partners LLP, a London-based boutique asset manager. Previously, he worked in various roles in Russia and China. Andrey graduated with a master’s degree in Management from London Business School and holds a degree in Economics from State University – Higher School of Economics in Moscow, where he majored in Financial Engineering and Mandarin Chinese. Andrey is a CFA charterholder. Read all articles
by Andrey Kuznetsov